Some insightful observations this weekend with stocks at all time highs

It is hard to believe that the end of the year is fast approaching. This weekend’s list of things to ponder covers a range of issues that caught my attention as I prepare to write my annual outlook for 2014. Will the economy continue to grow, are stocks under owned, what about Fed, rising credit risk and the question of “when or if to taper?” These are all important questions that all investors must answer as the new year rapidly approaches.

1) Only 20% of Economic Expansions Have Lasted Longer

With the duration of the current bull market now the 4th longest in history, we thought it worth noting just how unusual this business cycle has been. As the following chart shows, the current ‘expansion’ has lasted longer than 80% of all the 33 previous NBER expansionary periods. Of course, given projections from Wall Street to the Fed, there will never be another recession (by decree) ever again…

In last week’s “Things To Ponder” I shared various viewpoints discussing the potential market bubble. This week I also discussed why, due to the Fed’s ongoing monetary interventions, that stocks could conceivably rally another 30% from current levels.

Robert Huebscher has an excellent interview with Howard Marks covering a wide range of topics that are worth an entire read. Importantly, Howard discusses his views on why stocks could rise from current levels.

“I wrote a memo February or March called the Outlook for Equities and I enumerated the pros and cons. I found roughly six pros and eight cons. The trouble is that you cannot put them on a scale and figure out how to weight them. You have to decide which factors you consider more important. Just like so many other things in this interview we have been talking about, the confidence in equities had swung to the negative. In 2000, everybody would have said equities would give you 11%; they would have been unanimous in that. Now everybody says 6% or 7%.

What changed? The only thing that changed is that the companies doubled their earnings and the P/E ratio went in half.

To put it simply, I still think equities are under-owned institutionally and under-loved, and I like to buy assets like that.

Obviously it is a little less true today, but money has to go someplace. Where is it going to go? I don’t think it is going to go into bonds. You can only put so much into real estate, private equity, or hedge funds. If you put it in hedge funds, they will buy stocks anyway. So it bodes well for the stock market.

But, now the stock market is back to fully or fairly priced, at a P/E ratio of 16 or 17. They are not giving them away. But, I keep going back to what would you rather buy? I am not shilling for stocks because we are not in the equity business. But with bonds at these artificially low interest rates, stocks are less bad. Note that I did not say ‘good.’”

One of the major side effects of the ongoing interventions by the Federal Reserve has been a rise in complacency with regard to investment risk. That complacency, combined with the artificial suppression of interest rates to historically low levels, has led to a “chase for yield” in potentially some of the most dangerous places like the “high yield” (a much more marketable term than “junk”) credit market. Walter Kurtz noted:

“All of a sudden we find ourselves back in the frothy corporate credit environment that existed before the Fed struck a more hawkish tone in May (see discussion).”

“Perhaps some of the more publicized signs of corporate credit markets overheating have been the loosened underwriting standards in the syndicated loan market. The so-called ‘cov-lite’ loans often limit the lenders’ ability to take corrective action with the borrower when a company takes a turn for the worse. And the number of such deals has reached new highs.

Just as in the past, eventually someone will be suing the banks for selling these products. We will hear institutional investors testifying in court on how they were mislead by unscrupulous bankers about the ‘hidden’ risks. And some shareholders will be complaining about the amount of leverage the lenders put on the company. Everyone will all of a sudden develop amnesia about how these assets ended up in their portfolios in the first place. And those with capital and the ability to work out distressed situations will make a fortune.

For now, however, investors don’t seem to care – as long as it’s rated corporate credit it’s got to be good. It’s not 2006 quite yet, but we are certainly moving in that direction.”

I wrote this past week that I remain convinced that the Federal Reserve likely will not be able to taper any time soon due to a weakening economic environment. That problem will likely be exacerbated next year by the impact of the Affordable Care Act. As I stated:

“While there is much talk about the Federal Reserve potentially ‘tapering’ their purchases as early as 2014, the rising wave of deflationary pressures, both domestic and abroad, will likely keep the Federal Reserve engaged longer than currently believed.”

Tim Duy laid out a similar case with a twist which is that the Fed may be forced to “taper” despite the data.

“Interestingly, one of the costs of quantitative easing seems to be the inability to exit quantitative easing. This was revealed in today’s bond market sell-off after the minutes were released. Despite the Fed’s repeated efforts to use forward guidance to hold down rates, despite repeated reassurances that tapering is not tightening, Treasury yields gain almost 10 basis points at the 10 year horizon on even a whisper of tapering – and this after Bernanke’s dovish speech and Vice Chair Janet Yellen’s (perceived) dovish Senate hearing last week. Fine tuning policy with a tool of uncertain force is something of a challenge. Sufficient faith in an alternative tool would help clear the way for tapering despite this uncertainty, but after reading these minutes, I am somewhat concerned such faith is lacking.

Bottom Line: Clear evidence of the space we have been in for months. The Fed wants to taper, and is becoming increasingly nervous they will need to pull the trigger on that option before the data allows. That means that tapering is not data dependent. That means the policy deck is stacked with at least one wild card. And that sounds like a recipe for the kind of volatility the Fed is looking to avoid.”

If Tim is correct, then this could be extremely disruptive to the financial markets.

Interesting discussion by Stanley Fischer, former governor of the Bank of Israel and Glenn Hubbard, chairman of the Council of Economic Advisors under Bush, discussing that the Federal Reserve’s policy responses to the financial crisis were correct at the time. However, their early actions may have become a dangerous addiction.

But Mr. Hubbard is unsure if the current bond-buying program is having much positive effect on the economy, saying it does create the risk of asset bubbles.

He lays the blame on the government rather than Fed policy makers.

‘The problem is not the Federal Reserve, the problem has been the government,’ said Mr. Hubbard, the dean of the Columbia Business School. Rather than buying $85 billion a month in securities, the more appropriate policy response would have been a big government investment in infrastructure and other needs, he said.

Congress, which would need to approve that type of investment, has instead moved to curtail government spending in the past year.

Stanley Fischer, former governor of the Bank of Israel, agrees that the Fed’s early action helped avoid an even deeper crisis. He added that the Fed can successfully unwind its stimulus programs.

‘Everyone knows now about asset prices and presumably they’ll take that into account and moderate policy accordingly,’ he said. The Fed’s actions were ‘dangerous, but necessary.’”

Morgan Housel recently wrote a fantastic list of things that are consistently thrown out on the financial media that, upon reflection, is quite foolish. The whole list is worth reading but here a couple that I thought should have been included:

“[Portfolio Manager On TV] It’s Time To Buy”

Sure it is. Of course, they told you the same thing in 2001, 2002 and 2008.

“We Have A Buy Rating On That Stock”

Of course, you do. You also have a buy rating on every other stock that you underwrite for a fee.

“Operating and Pro-forma Earnings”

When you can’t report GAAP earnings because you will miss estimates – fudge it with accounting gimmicks.

“Stocks Are Cheap Based On Forward Estimates”

True, of course forward estimates are achieved just about as often as “unicorn sightings”

There will be a lot happening at the Master Investor Show on 25 March, and everyone has their own…

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